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Client Update: ATO releases draft rulings on foreign private equity investors

17 December 2009

In brief: Partner Michael Rigby (view CV) looks at two new important draft tax determinations released by the ATO yesterday dealing with foreign investors in Australian assets.

Partner Charles Armitage (view CV) discussed the draft determinations on Boardroom Radio.

Background

The two draft taxation determinations that are relevant to private equity and other foreign investors in Australian assets are:

  • TD 2009/D17 – Income tax: treaty shopping – can Part IVA of the Income Tax Assessment Act 1936 apply to arrangements designed to alter the intended effect of Australia's International Tax Agreements network?
  • TD 2009/D18 – Income tax: can a private equity entity make an income gain from the disposal of the target assets it has acquired?

Not surprisingly, the draft determinations answer both of these questions with a 'Yes'.

The draft determinations are the ATO's response to the uncertainty arising from its much publicised, and ill-fated, attempt to prevent money received by a member of the Texas Pacific Group from the sale of its shares in Myer Holdings Limited from leaving Australia. From press reports it appears that the company that sold the Myer shares was resident in the Netherlands, the Netherlands company was owned by a Luxembourg incorporated company and the Luxembourg company was owned by a Cayman Islands entity. It appears that the ATO's position was that the profit on the sale of the Myer shares was income having a source in Australia, and that the tax treaty between Australia and the Netherlands did not exempt that income from Australian tax because the use of the Netherlands company was considered to be a scheme subject to the anti-avoidance provisions of Part IVA of the Income Tax Assessment Act 1936 on the basis that it had a dominant purpose of ensuring that any profit on sale was exempt from Australian tax.

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Submissions

The ATO has sought comment on the draft determinations. Comments are due by 29 January 2009.

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Tax Determination 2009/D18 – when profit on disposal of assets is income

Since December 2006 the capital gains tax provisions generally apply to non-residents only in relation to disposals of real property in Australia, non-portfolio holdings of shares in Australian resident companies or units in Australian unit trusts if more than 50 per cent of the value of the company's or trust's assets is attributable to Australian real property and assets held by a non-resident in connection with a business carried on in Australia through a permanent establishment. TD 2009/D18 is a reminder that profits earned on the disposal of other assets (for example, shares in Australian companies that are not land rich) may still be subject to Australian tax if they are income that is sourced in Australia.

TD 2009/D18 applies to 'private equity entities'. This term is undefined in the draft determination. The draft indicates that the Commissioner's understanding of a typical private equity acquisition is that it involves:

  • an acquisition of interests in a target entity often by a non-resident private equity entity;
  • the holding of the interests for a period during which operational improvements are usually made to increase earnings over the life of the investment and to enhance the value of the entity; and
  • the subsequent sale of the target assets.

The draft determination states that whether a profit on the sale of a private equity investment is income depends on the facts and circumstances of the particular case. A profit is likely to be income if it arises from a profit-making transaction entered into in the course of carrying on a business, or from a one-off transaction if the asset that generates the profit was acquired in a business operation or commercial transaction entered into for the purpose of generating a profit by the means giving rise to the profit. The draft determination states that whether a profit on the realisation of a private equity investment is income based on these principles will depend among other things on the investment strategy agreed to by the parties before the investment is acquired, the form and substance of the arrangements and structures used, and a balancing of the following factors that the Commissioner identifies as the matters on which returns on a private equity investment depend on:

  • cash flow from operations;
  • operational improvements to increase earnings over the life of the investment; and
  • disposing of the interest in the target entity at a profit.

The draft determination also states that the guidance provided by Taxation Ruling TR 92/3 on the circumstances in which profits on isolated transactions are income is also relevant in determining when profits made on realisation of private equity investments are income. Factors mentioned in that ruling include the nature and scale of the taxpayer's activities, the amount of money involved in the transaction, the manner in which the transaction is carried out and the timing of the transaction.

Comment

The following points can be made in relation to TD 2009/D18:

  • Profits on the sale of investments can in some circumstances be income rather than capital gains. This issue has arisen domestically in relation to managed investment trusts and the Federal Government is addressing the issue in that context by allowing such trusts to elect capital gains treatment in relation to certain assets. Draft legislation on that measure was released last week. (See our Client Update: Proposed changes to taxation of MITs' disposal of investments.)
  • If the private equity investor's strategy is to make 'operational improvements' with the intention of creating value and then selling at a profit, the ATO is more likely to view any profit on sale as having an income character.
  • If the strategy is to invest for an indefinite time for the purpose of earning an income stream in the form of dividends or other distributions, the investment is more likely to be on capital account.
  • Evidence as to the investment strategy is therefore important.
  • A profit on the disposal of an asset can be income even if it is the entity's sole asset.
  • The draft determination does not discuss the circumstances in which the profit on disposal of an investment by a non-resident is income that has an Australian source. This is relevant because non-residents are only taxed on Australian source income. The underlying assumption appears to be that if the investment is in an Australian asset the source of the income will be in Australia. However, this would not necessarily be the case if a non-resident sold shares in a foreign company that invested in an Australian asset.
  • There is no definition of a 'private equity entity'. However, investments of the type described in the draft determination should be distinguishable from corporate acquisitions that are made in order to achieve growth in a corporate group. While these may also involve 'operational improvements' of the type mentioned in the draft determination the strategy is less likely to involve an intention to sell at a profit after those improvements have been achieved. Similarly, long-term investments in infrastructure assets clearly have a more capital 'flavour' than the types of investments described in the draft determination.
  • Profits derived by other categories of foreign investor may also be Australian source income. This may be the case, for example, with certain funds whose business involves regular trading in investments or the acquisition of investments for the purpose of sale at a profit.

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Taxation Determination 2009/D17

In TD 2009/D17, the ATO discusses the circumstances in which it may apply the general anti-avoidance provisions of Part IVA to deny a non-resident benefits under a tax treaty that would otherwise be available.

The draft determination is concerned with the situation where non-resident investors establish a company that is resident in a country with which Australia has a tax treaty, and that company acquires an Australian asset that is later sold at a profit that has an income character. Ordinarily, the business profits article in the treaty would prevent Australia from taxing that income profit if it was not derived in connection with a business carried on by the non-resident company through a permanent establishment (ie a branch) in Australia. The draft determination provides the following example of a situation in which Part IVA may be applied to deny the treaty exemption to the non-resident investor:

  • A Dutch holding company establishes a wholly owned Australian incorporated company to acquire an Australian resident target company.
  • The Dutch company is owned by a Luxembourg incorporated entity that is owned by a Cayman Islands resident entity. The Cayman Islands entity is controlled by US resident investors and a private equity group.
  • The Australian company was acquired for the purpose of selling it at a profit via an IPO.
  • There is no commercial reason for using the Luxembourg and Dutch companies in the ownership chain.
  • The Dutch company sells its shares in the Australian holding company at a profit.

The draft determination states that this structure gives rise to a tax benefit for Part IVA purposes for the Caymans entity because if it acquired the Australian holding company and sold it at for a profit that was income that would be liable for Australian income tax without any tax treaty relief. Further, in the absence of commercial reasons for the interposition of the Luxembourg and Dutch companies between the Caymans entity and the Australian holding company, the draft determination states that it would be concluded that the dominant purpose would be the obtaining of that tax benefit. The implication of this is that the ATO would regard the Caymans entity as the taxpayer liable for Australian tax on the profit on the sale of the investment.

In determining whether there is a commercial purpose for the use of the Luxembourg and Netherlands companies in the structure described in the example, the draft determination considers the following features to be relevant:

  • both of the companies were holding companies whose primary undertaking was to hold shares in the next company in the ownership chain;
  • each of the companies has little or no other business activity; and
  • there are no regulatory reasons for the companies to be utilised.
Comment

The following points can be made in relation to TD 2009/D17:

  • Even though it is assumed that the investors in the Caymans entity are US residents, it is assumed that the alternative investment would involve the Caymans entity investing directly into the Australian holding company. Australia has a tax treaty with the US. If the US investors invested directly into Australia, or used a US entity to invest into Australia, no Australian tax would be payable on the profit on sale of the Australian holding company.
  • In circumstances where a US investor established a Netherlands holding company to invest in Australia and the Netherlands holding company realised the investment for a profit that was of an income character, Part IVA should not apply if the US investor could obtain treaty protection under the US-Australia treaty if it invested directly. The difference between this case and the example in the draft determination seems to be that for non-Australian tax reasons a Caymans entity is used in the structure. The Luxembourg entity has no Australian tax significance because it is used to ensure no Netherlands withholding tax is paid when the Netherlands company pays dividends.
  • This illustrates the difficulty in applying Part IVA, rather than specific treaty rules, to deal with 'treaty shopping'. The ATO's position appears to be that it will not trace through entities established in tax haven jurisdictions to act as pooled investment vehicles even if all of the ultimate investors are resident in countries with which Australia has tax treaties, and the pooled investment vehicle has clearly not been established to obtain Australian tax benefits.
  • If the Netherlands holding company had other activities, including, for example, holding shares in companies in other countries, then it should be less likely that it would be disregarded under Part IVA.

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